lifestyle leader

It is a holiday week here in the US, so I have been only passively following the developments of the past few days. But as the global reaction to the Dubai Government's request for a six-month restructuring and standstill on Dubai World's, and its subsidiary Nakheel's, debt makes its way to the US markets this morning (the US was closed for the Thanksgiving holiday yesterday), I have been thinking about the implications of the decision over my morning espresso (or 5 to be exact).

Briefly, a few thoughts on the decision:

-Legalese aside, this is a default and the markets are treating it as such. S&P has said that under its default criteria, Dubai World's restructuring may be considered a sovereign default, that is the failure of the sovereign to provide timely financial support to a 'core government-related entity.' The Dubai Ministry of Finance's bogus assertion that they are simply asking creditors to 'wait until May' is ludicrous.

-You can view the risk of contagion from two angles. One perspective would have us shaking in our trading smocks, worried that much like South East Asia in the late nineties, the bursting of a property bubble backed by the sovereign in an opaque legal and financial environment would quickly spread to other, similarly fragile economies. Just look at the spike in borrowing costs over the past 48 hours for not just Dubai, but regional peers like Abu Dhabi, not to mention emerging markets more globally. Compounding this fear is the still fragile state of the international financial system. On the other hand, and this is the perspective I have come to hold over this morning's coffee, Dubai is a unique beast, and its fallout should be fairly small. It is a property-driven bust with no economic muscle to speak of besides construction and services. It was always destined to burst in spectacular fashion amidst the global financial crisis. Its development model fundamentally relied on cheap borrowing costs, conspicuous consumption and financial services. Unlike its regional peers, it holds no natural resource wealth or, to my knowledge, potential, which is why it staked its future on becoming a global financial center. The implicit guarantee that the Dubai government, or even Abu Dhabi, would back Dubai World's obligations was a miscalculation, and now creditors are left uninformed and, until Monday at least, out in the cold. Its regional peers hold massive forex reserves, recovering oil and gas revenue and sovereign wealth funds that back most of their government-owned entities (companies similar to Dubai World.) The prospect of a similar situation developing in Abu Dhabi is highly unlikely. This is why, once markets settle next week, the contagion should be minimal.

-But the prospect of contagion, and current panic over Dubai's position, highlights the critical importance of information to the functioning of financial markets. Dubai World's fragile position has been apparent for months, and as I mention above, the assumption was that it was fully backed by the government. But in an opaque political and financial environment, this assumption was really a matter of faith. It was never clear that the government would fully back Dubai World's debt: that's why, as Willem Buiter points out, private creditors demand and earn higher risk premiums on property developers than they do on sovereign debt. I think this will raise interesting questions about, and perhaps greater scrutiny of, sovereign enterprises and wealth funds worldwide. Limited liability extends to the owners of these firms (that is probably a gross generalization), even if the owner is the state itself. As Buiter says, creditors will have to manage this risk the way they always do: hope for the best. Greater transparency will allow investors to more accurately price this risk. Finally, the current anxiety is compounded by the lack of information coming out of the Ministry of Finance. This is partly a matter of poor timing, with some markets closed for holidays in the Middle East and US. The government of Dubai has essentially told investors to wait until Monday, which to globally interconnected financial markets can be a lifetime. Even in an opaque environment, a timely and transparent response can go a long way towards stabilizing market expectations and limiting the contagion.